Future retirees more vulnerable to income shocks

Increased use of annuities and reverse mortgages could improve outcomes

The two major shocks that hit the elderly today are a spike in medical expenses and a sharp drop in income upon becoming a widow. While some of today's retirees are financially fragile, most appear able to absorb shocks without incurring hardship, according to a new issue brief from the Center for Retirement Research at Boston College.

But future retirees may not be so lucky. Going forward, retirees will get less of their income from Social Security and traditional pensions and more from financial savings in 401(k) plans. Having these savings gives them greater flexibility to respond to shocks, the report noted. But tapping the nest egg comes at the cost of having less to cover ongoing expenses.

"Future retirees are more likely to experience financial fragility unless they reduce their fixed expenses or draw increased income from their assets," the report concluded.

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Nearly 80% of the spending of a typical elderly household goes to secure five basic needs: housing, health care, food, clothing and transportation. These needs account for an even greater share of the expenses of lower-income households, single individuals and households that rent or have a mortgage.

If necessary, households can cut back on entertainment, gifts and other nonbasic items, such as cable TV or a cell phone. But the typical retiree cannot cut overall spending by more than about 20% without experiencing hardship — defined as cutting back on needed food or medication as a result of a lack of funds.

Most Americans enter retirement as married couples, and the wife typically outlives her husband. The study found that the consumption expenditures of widows — what's needed to maintain their standard of living — are generally about 75% of what the couple had spent. But Social Security and employer pension plans provide significantly less.

A previous study found that women widowed between 2002 and 2004 typically got 62% of the couple's Social Security benefit and only half of its employer pension benefits. The report suggests that for married women entering retirement over the next 25 years, half will have 62% or less of the couple's income when widowed, and one in four will have 55% or less.

To maintain their standard of living, future retirees increasingly will rely on income drawn from financial assets accumulated over their working careers. And many households retiring over the next quarter century could lack sufficient savings.

Going forward, retirement incomes will replace a smaller share of preretirement incomes than they do today. The projected decline in retirement income replacement rates for Baby Boomers and Gen Xers ranges from 5% to 21% less than the replacement rates of current retirees who are in their 70s or older.

"These projections may understate the likely decline in replacement rates because they assume that households annuitize most of their savings at an actuarially fair rate, which provides more income per dollar than a safe withdrawal strategy aimed at minimizing the chances of running out of money," the report said. In reality, very few retirees annuitize.

"The most effective response for households approaching retirement is to increase their retirement income and reduce their fixed expenses," the report said. "Working longer, annuitizing wealth, and taking out a reverse mortgage would increase retirement income."

Changing behavior could change outcomes. And financial advisers could capitalize on an opportunity to create more stable retirement income for clients while consolidating more assets for their firms, according to a separate study by the LIMRA Secure Retirement Institute.

The LIMRA study found that retiree annuity owners feel more confident that they are more likely to afford their preferred retirement lifestyles — even if they live to age 90 or older — than retirees who do not own an annuity. Twice as many retirees who work with an adviser own an annuity compared with retirees who don't work with an adviser, by a margin of 56% to 28%, the report said.

The Institute also found that the annuity ownership rate is nearly 70% higher among households that have completed a formal retirement income plan than households without plans. And nearly half of affluent and high-net-worth clients with assets of $500,000 or more who have with a formal plan have consolidated 90% or more of their assets with their adviser — more than double that of clients with a similar amount of assets who do not have a formal retirement plan.

Yet LIMRA research shows there is a large unmet need and a potential opportunity. Advisers report they have completed formal retirement income plans for only 35% of their retired clients, and more than 50% of affluent and HNW clients do not have formal plans.

It sounds like the creation of more formal retirement plans could be a win, win, win by helping to stave off a future retirement crisis, increasing retirement income security and bolstering many advisers' bottom lines by consolidating client assets.